Watch your Language with Oil and Gas Leases in Ohio (#2)

Just as Faye Dunaway’s character in the
movie Chinatown was both mother and
sister to “Katherine”, an oil and gas lease in Ohio (and other jurisdictions) is
both a contract and a lease.

An oil and gas lease is a lease, not
because of its name, but because it is a transfer of a part of an interest in
land for a specific period of time, or “term,” in exchange for the payment of
rent, royalties or other standard of value. In other words, it fits the classic
definition of, and contains the common characteristics of a lease. In an oil
and gas lease, mineral rights/interests of the “dirt” are leased instead of the
actual “dirt” itself. Both the dirt and the oil and gas underneath the same are
“parts” of real property that can be leased.

As a transfer of property, the lease,
like a deed contains certain written and unwritten (implied) covenants. A
deed’s covenants, for example include the covenant that the grantee shall have
quiet possession, that the grantor is lawfully seized (in fee simple) of the
property and a covenant that the grantor will execute such further assurances
of the land as may be requisite. A typical lease of real property contains the
implied (sometimes express) covenant of quiet enjoyment (or possession); and
oil and gas leases are held to contain the implied covenant of reasonable
development.

An oil and gas lease is also a contract because it meets the
following, legal definition of the same: “an agreement between two or more
parties creating obligations that are enforceable or otherwise recognizable
at law.” For an oil and gas lease
to be an enforceable contract, the following general, contractual requirements
must be present: (i) meeting of the minds; (ii) consideration; (iii) capacity;
(iv) legality; (v) definiteness; and (vi) the lease must be in writing. The
significance of an oil and gas lease also being a contract is that the general
law of judicial contract interpretation applies. Namely, that courts
will uphold language in commercial agreements, unless it is contrary to
statutory law or public policy (and will not add language to the contract). As
the reader may recall from other “Watch
Your Language” articles for this Blog, because of this judicial deference
to “commercial language”, you must say what you mean, precisely, or a
judge will decide what you meant.

Apparently, the plaintiffs in the recent
Supreme Court of Ohio case, Alford v. Collins-McGregor Operating Co.,
Slip Opinion No. 2018-Ohio-8, lost sight of the dual nature of oil and
gas leases, the rules of judicial interpretation of contracts, and the failure
to say, precisely what they meant to say therein.

The facts of the case are as follows:

Seven individual landowners (the “Landowners”)
hold interests in approximately 74 acres of land in Washington County, Ohio.
The land is subject to an oil and gas lease (the “Lease”) entered into in 1980,
between the owners of the property at that time and Collins-McGregor Operating
Company (later assigned to Winston Oil Company). Collins-McGregor and Winston
were the appellees in this case and will be referred to hereinafter as the “Oil
and Gas Companies”. According to the Lease, “[T]he
sole and only purpose [of the lease is to permit] mining and operating for oil
and gas and laying pipe lines, and building tanks, powers, stations, and
structures thereon, to produce, save and take care of said products.” In
return for permission to mine the land, the Oil and Gas Companies committed to
make royalty payments based on the amount of gas produced from the land and to
deliver a portion of the oil produced from the land to the Landowners.

The Lease further provides that it “shall remain in force for a term of One (1)
years from [the effective] date, and as long thereafter as oil or gas, or
either of them, is produced from said land by the lessee.” However, other
than the specific term and general purpose, the Lease contains few other
material terms. The Lease is conspicuously silent as to details of drilling and
production. For example, the Lease contains no requirement or other information
re: the specific number of wells or the planned depth of any well. The Lease
also does not disclaim any implied covenants (such as the implied covenant of
reasonable development).

Pursuant to the Lease, a well was
drilled in 1981, and has produced oil and gas in paying quantities since then
from a formation called the Gordon Sand.
As of the date of the opinion, however there had not been any production from
the land at any depths below the Gordon Sand, where the Marcellus and Utica
formations are located—(the Oil and Gas Companies claimed that they failed to
explore whether production can be obtained from those deep formations because they
did not have the equipment or financial resources required to do so).

In November of 2015, the Landowners
filed suit against the Oil and Gas Companies alleging that they breached
several implied covenants, and improperly failed to explore or drill for oil at
depths below the Gordon Sand. The Landowners sought a judgement declaring the
portion of the Lease covering depths below the Gordon Sand terminated, so that
the Landowners could presumably contract with an alternative oil/gas company
willing to drill into the Marcellus and Utica formations.

Among the implied covenants that the
Landowners claimed the Oil and Gas Companies breached are the implied covenant
of reasonable development and an implied covenant to explore further. The Oil
and Gas Companies described the judgement sought by the plaintiffs as “horizontal
forfeiture” (i.e., forfeiture of the right to drill to a particular horizontal
layer or formation beneath the surface) but moved to dismiss the case, arguing
that Ohio law does not recognize the implied covenant to explore further, or
the remedy of horizontal forfeiture. The trial court agreed with the Oil and
Gas Companies and dismissed the case, holding that under the plain terms of the
Lease, the still-productive well drilled in 1981 was “sufficient to hold the Lease across all acres and at all depths.”
The Fourth District Court of Appeals affirmed, holding that Ohio law neither
recognizes an implied covenant to explore further, nor partial, horizontal
forfeiture of oil and gas rights as an available form of relief. The Landowners
then applied to the Ohio Supreme Court.

Arguing before the Ohio Supreme Court, the
Landowners cited several 5th appellate district decisions that
recognized the existence of an implied covenant to explore further. The Oil and
Gas Companies countered that while cases from one appellate district in Ohio may
have recognized such a covenant, none actually applied the covenant. Moreover,
the Oil and Gas Companies argued that there was no need to recognize a new,
state-wide implied covenant because the covenant of reasonable development
provides sufficient protection for landowners. Furthermore, the Oil and Gas
Companies argued that the plain language of the Lease contained no development
details, no new covenants and no requirement to partially forfeit the lease, so
it was not the court’s job to do any more than interpret the contract as
written, and apply the only, universally recognized, implied (oil and gas lease)
covenant; the covenant of reasonable development.

The
Supreme Court of Ohio agreed with the Oil and Gas Companies and affirmed the
ruling of the 4th Appellate District.

In its opinion, the Supreme Court of
Ohio first cited precedent, reiterating the dual nature of oil and gas leases. “Oil and gas leases are contracts, and
therefore, ‘the rights and remedies of the parties to an oil and gas lease must
be determined by the terms of the written instrument’ [however],
notwithstanding this principle, we have long held that oil and gas leases are
ordinarily subject to an implied covenant to reasonably develop the land.”

The court then explained that while the
covenant of reasonable production is generally a protection implied to
landowners (lessors), its standard is to only “impose on the lessee the obligation to act as a reasonably prudent operator
would as it develops the land under the lease.” Applying the standard to
the facts of the case, the court reasoned that since drilling below the Gordon
Sand formation would cause the Oil and Gas Companies to lose profits in the
venture, limiting production to the Gordon Sand formation only, would be
reasonable. Citing the Oklahoma Supreme Court, the Ohio Supreme Court in Alford reasoned that ignoring the profit
motive from the “reasonableness equation” “is
to ignore the very essence of the contract.”

The court also agreed (quite
emphatically) with the Oil and Gas Companies’ contract argument; stating, that the
proposition of the rights and remedies of the parties to an oil and gas lease
being determined by the terms of the written instrument was “uncontroversial” and “what this court has recognized since 1897.”
The court reasoned that if the parties intended there to be specific
drilling requirements beyond “reasonable development”, they would have
specified same in their oil and gas…contract. However, the court noted that “the lease [in Alford]does not contain a disclaimer
of implied covenants, nor does it otherwise address whether any specific number
of wells must be drilled or the depth to which any wells must be drilled.
As such, the lease, according to the Ohio Supreme Court was subject to the
implied covenant of reasonable development, but no other covenants, express or
implied.

What
is the moral of this story?

Watch Your Language with oil and gas
leases, and say what you mean, precisely, or a judge will decide what
you meant. While oil and gas leases are often convoluted, and written in
small font, “standard” forms; they are contracts, not holy tablets of stone,
and accordingly, are negotiable. If you are expecting certain formations to be
drilled, say so. If you want a minimum of wells drilled on your property, spell
that out. Certainly, arguing for these types of clauses does not guarantee they
will be included in your lease, but failing to include them before you sign will
almost always guarantee that they will not be part of you contract.

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